Inflatin: a tiger by the tail; H. Hazlitt

f"'/f\ only as much purchasing power ~ 37 cents had then. Some people are trying to tal comfort from the fact that tl annual rate of price rise, on tl official index, is still slightly lef than 6 per cent a year. Is th~ worth worrying about? I think it is. Let me quote a excerpt from a calculation mac in its bulletin of August 26, 196 by S. J. Rundt & Associates, leading consulting firm on inte national monetary affairs: An American who starts to wo: at 18 and who must live with 5.5 p cent per annum inflation will see pric double before he is 31. And he will s prices doubled for the third time his adult life ahead of his 57th birt day. And if a healthy constitution al modern medicine keep him going, . will see prices doubled for the four time prior to age 70. In other wore when he reaches 70 he will have 1970 INFLATION: A TIGER BY THE TAIL 71 pay 16 times as much for whatever he buys as he did when he started out in gainful life. His greenback will have shriveled to 6 1;i cents, or by 93.75 per cent.

If we carry this calculation on to the young man's 83rd birthday, prices will have doubled once more; he will have to pay 32 times :lS much for equivalent goods and services as he did when he took :he first job; his dollar will have ;hrunk to a mere 31/8 cents. The only trouble with the fore ~oing calculation is that it is al ~eady outdated. Prices have re tentlybeen rising at an annual 'ate close to 6 per cent. At such L rate prices would double every '.2 years instead of every 13. low It Began How did our present inflation ~et started? And how did we get o the point where we are? Our nflation came about, to put it ,riefly, because for 30 out of the last 38 years the Federal govern aent has been spending more :loney than it has taken in in axes, and has paid for the differ nee by printing irredeemable aper money, At the end of 1939, he nation's stock of money, as leasured by currency in circula ion and demand bank deposits, ,as $36 billion. Today it is $200 Hlion, almost a sixfold increase.

Inflation is caused, always and everywhere, by an increase in the stock of money and credit in ex cess of any increase in the supply of goods and services. The five-or sixfold increase in the supply of money in the last thirty years might have resulted in something like a five-or sixfold increase in prices if it had not been for a substantial increase also in the production of goods and services in that period. The official index of industrial production has in creased more than fourfold in that period. This is the main reason why the increase in prices was not as great in that period as the in crease in the stock of money, In trying to forecast the proba ble future of inflation, it is im portant to keep in mind that this inflation is not something confined to the United States. In the same period, most countries have in flated even more. Though the American dollar at the end of 1968 bought only 83 per cent as much as it had ten years before, the German mark bought only 80 per cent as much, the Swiss franc only 76 per cent as much, the Brit ish pound only 74 per cent as much, the French franc only 69 per cent as much, the Japanese yen only 62 per cent as much, the Chilean escudo only 11 per cent as much, the Argentine peso only 7 per cent as much, and the Brazil ian cruzeiro only 2 per cent as 72 THE FREEMAN much. The reader can imagine what this has meant in economic distortions and disruptions and in personal tragedi es.

Government Policies Let us come back to the point that inflation, always and every where, is caused by the policies of governments, not of private in dividuals. It is brought about di rectly by governmental monetary policies, and indirectly by govern ment fiscal policies. Why do gov ernments launch such policies? Usually they do so by default, most often by getting into a war. The great chronic inflations of this century· were triggered by World War I and then World War II. A government at war has to increase its spending suddenly and enormously; it usually lacks the courage to increase taxation cor respondingly; in fact, it usually regards such a course as impos sible. It usually also decides that it cannot even issue bonds to be paid for out of savings to finance the difference between its expend itures and its revenues. So in effect it finances its deficits by printing paper money. The in flation is then on. Prices soar.

But when the war is over, the country does not go back to its previous lower level of spending. One reason is that prices have soared; all government services cost more. Another reason is tha vested interests have already beel established in favor of continuinJ and even increasing the wartiml level of spending. Still anothe: reason is that there is great feal however unjustified, that if th budget is now overbalanced b; cutting back expenditures, and ; surplus develops which is used t payoff accumulated national debi it win precipitate a deflation, wit: terrible consequences in bankrup1 cies, unemployment, and depreE sion. In brief, vested interests ar created in a continuance of infl~ tion. Theories grow up rationalh ing and glorifying inflation. Frol the middle thirties to the middJ sixties these theories were typ cally represented by Ke,ynesianisn The theories differ in detail, bt: broadly they run something Iili this: When there is depression ( unemployment it is because pel pIe do not have enough "purcha: ing power," or do not spen enough even of the money thE have because they think prices aJ going to go still lower. If the go' ernment runs a deficit and prill' more money, this will increase d mand for products and thereio] increase employment. This will ll< bring on "true inflation" if tl additional money is not issued too great amount; but even if does increase prices, this will i 1970 INFLATION: A TIGER BY THE TAIL 73 crease profit margins and so stim ula te more production and more employment.

N ow these theories combine multiple fallacies with some ele ment of truth. When there is stag nation and unemployment, it is learly always because there is some lack of coordination between prices, wages, and other costs. The ap propriate remedy is to restore this ~oordination, usually by a lower lng of certain key costs, such as Nage rates, in relation to final Jrices. Under today's conditions, ;he resistance of powerful labor lnions tends to make it "impos ;ible" to lower wage rates. So the >nly apparent remedy is to in ~rease prices. itimu/ative Effects in the :arly Stages of Inflation In its early stages inflation does >recisely this, and so tends to 'estore demand, prices, and profit nargins, and hence employment lnd production. This is the ele nent of truth in the theories that nflation is necessary or desirable. :t is this stimulative effect that nakes inflation initially popular.

3ut this is only the early effect of ,he first "dose" of inflation. When )usiness activity is restored and full employment is restored, costs )egin to catch up again, or even ,nee more race ahead of final >rices. The price of raw materials rises. Unions demand higher wages - including both' "cost of living" increases and "productiv ity" increases. Soon profit margins are reduced again or even wiped out in certain lines, and there is a demand for a second dose of inflation. It is particularly instructive to study what happens to interest rates. Whenever business is slack, governments are under great pres sure to keep interest rates down, to "encourage borrowing." There is apparently a simple way to do this. Interest is the money paid to borrow loanable funds. It seems to the government that the simple way to reduce interest rates (and hence, it is argued, to reduce costs of production) is to increase the supply of loanable funds by in creasing the supply of credit and paper money. And for a while this may indeed reduce interest rates. But soon another conse quence follows. As a result of the increased supply of money and credit, prices rise. Let us say that as a resuli of an increase in the stock of money by 5 per cent, prices rise about 5 per cent. Then businessmen will have to borrow 5 per cent more than they did be fore in order to do the same vol ume of business. Hence, the de mand for money will increase 5 per cent, so catching up with the 5 per cent increase in the supply 74 THE FREEMAN Februar1) of money; and as a result inter est rates will tend to go higher again.

Pressure lor More Money Then there will be political pres sure for a second dose of inflation, say another 5 per cent increase in the supply of loanable funds, to bring interest rates down again. This will have the result also of increasing prices of commodities and of increasing the demand for borrowed money, once more rais ing interest rates, and leading to pressure for a third dose of in flation to get them down again; and so on. (To simplify the exposition, I have been assuming here that prices will increase roughly in proportion to increases in the money stock. Of course, in the earlier stages of an inflation this is unlikely to happen. Because of increasing annual production of goods and services, and for other reasons, the average of prices is likely to go up less than the stock of money is expanded. But for the moment we can ignore such quali fications.) But there will now also be an additional effect. Suppose, as a re sult of an annual dose of inflation of about 5 per cent a year for the past few years, prices have been rising at a rate of 5 per cent a year. Then a lender, asked to lend his money at an annual rate of 5 per cent, will say to himself: "WhJi should I? Even if the loan is safe and I get my principal back a yea} from now, it will probably bE: worth some 5 per cent less in pur· chasing power than it is wortl now. Therefore, I am in effect be· ing asked to lend my money at ::; zero rate of interest."

So on top of his regular interes1 the lender will want what is callec a price premium to compensatE him for rising prices. This is thE reason why interest rates havE now soared in this country to thE highest levels since the Civil War If prices have risen nearly 6 pe] cent in the last twelve months an( are expected to rise as much it the next twelve months, and so Ol indefinitely, then even a lendel who is getting 9 per cent on hi: money figures he is getting a rea interest of only about 3 or 4 pe: cent net. 40 Per Cent Loss In Seven Years Let me cite just one concrete iI lustration, from the DecembeI 1969, letter of the First Nationa City Bank of New York, of th combined effect of rising interes rates and depreciating money s far: "The market value of th U. S. Treasury 41Jt:s of 1992/8j issued only seven years ago at th highest rate permissible under th legal ceiling, has dropped sine 1970 INFLATION: A TIGER BY THE TAIL 75 then by about 30 per cent. After allowing for the loss of the pur chasing power of the dollar, the real loss suffered by anyone who bought the bonds when they were issued is somewhat over 40 per ~ent."

What happens to interest rates is merely an illustration of what tends to happen throughout the aconomy. If commodity prices have been rising at an annual rate of nearly 6 per cent, and people ex ~ect them to continue to rise at ~hat rate, then everybody tries to ~ompensate ; everybody tries to tdjust his interest, rents, prices, lnd wages accordingly. Individual Norkers, and especially unions, if .~hey expect a 6 per cent ann ual dse in consumer prices, will ask for a 6 per cent annual "cost of living" rise in wages to compen jate. They will want thIs on top )f any "productivity" or other in ~rease to which they otherwise ~hink themselves entitled. Thus, ~osts of production will rise as :ast as prices, if not faster. Real )rofit margins will not increase. rhere will he no expectation of any ~eal increase in profit margins. In lrief, a constant rate of inflation vill cease. to have any stimulative ~ffect on business - on buying, pro luction, or employment.

This applies not only to an in lation of a "mere" 6 per cent a 'ear. It applies just as much to any constant rate of inflation whatever - 10 per cent, 50 per cent, 100 per cent a year. Higher than Expected We arrive, then, at the general principle that any rate of inflation that is generally expected has no stimulative effect on the economy, even if the expectation continues to be fulfilled. For an inflation to have a stimulative effect, it must be unexpectedly high; the rate must come as a surprise to the business community, so that it is not already discounted in current prices and costs. This is almost equivalent to saying that the rate of inflation, if it is to continue to have a stimulative effect, must be accelera tivee But we finally arrive at the paradox that even an in creasing rate of inflation will have no stimulative effect if the ac celeration itself is generally ex pected; it must always be greater than what is generally expected, no matter how high expectations may be.

And if the rate of inflation is suddenly less than has been gen erally expected, the result is likely to be a crisis followed by a reces sion. This is true at any level of inflation. It will be true if the ex pected rate of inflation is "only" 5 per cent but proves to be zero. It is important to understand just why this is so. The business 76 THE FREEMAN February community (and in this term I in clude not only producers but con sumers) is always operating on expectations. These expectations at any moment are built into ex isting prices. An obvious and out standing example is the stock market. The existing price of any stock does not merely reflect its present yield or the company's present earnings per share; it re flects what the company is ex pected to earn and what the stock is expected to be worth in the future. The prices of all basic com modities on the speculative mar kets - wheat, cotton, copper, silver - reflect foreseeable or expected future conditions of supply and demand. The present price of land and houses reflects not only the existing inflation, but the expected future rate of inflation - what buyers and sellers expect the state of inflation to be a year, two years, twenty years from now. So if something happens to bring even a 5 per cent annual rate of inflation to a halt - or if it is ex pected very soon to come to a halt - buying will suddenly fall off, prices will drop, unemployment will rise, and we will find our selves in a mild or severe crisis.

I must mention still an addi tional factor to be considered. All businessmen must constantly plan ahead. A typical retail haberdasher may need to plan only six months ahead-for example, to order from the wholesaler in the spring the clothes he wants to stock in the fall. But a manufacturer may need to plan his output, both in kind and in quantity, a year or two years ahead. A builder or a manu facturer deciding whether to ex pand his plant may need to plan three to five years ahead. And so on. All these investment plans call for a present outlay of money tc be recouped, hopefully with a profit, at the completion of a cer· tain period. Nearly all plans madE: during an already prolonged in· flation are consciously or uncon· sciously based on the assumptior of the continuance of this infla· tion. If this assumption is disap pointed, there will be widespreac losses, bankruptcies, and unfin· ished proj ects; and, of course, un· employment.

Attempts to Compensate One further point must be madE about the role of expectations. Ir the early stage of any long-tern inflation (and this stage may per sist for several years) the rise ir prices does not keep pace with thl increase in the money stock, be cause most people do not regar< the rise in prices as permanent In the middle stages of inflation people begin to assume first tha the past price increases are per 1970 INFLATION: A TIGER BY THE TAIL 77 manent and then that the past rate of price increase is likely to continue into the future. They therefore try to make. compen sating readjustments. But these widespread efforts to make pro tective readjustments (demand ing higher wages, higher inter est, higher rents, borrowing more, buying in advance, and so forth) tend in themselves to increase the rate of price increase still further. This explains why it is an illu sion to assume, as so many infla tionists have done in the last dec ade or two, that some uniform "moderate" rate of price rise - 3, 4, or 5 per cent - can be kept go ing year by year indefinitely by some uniform corresponding in crease in the money supply or othe~ means. It is not merely that the expectation of such a price rise will lead speculators, invest ors, entrepreneurs, workers, lend ers, borrowers, consumers, and so on to try to anticipate it, thus de stroying any stimulative effect, but that these countervailing and cost-raising actions by private in dividuals and groups will put po litical pressure on the government and the monetary managers to in crease the rate of inflation to pre vent unemployment and depres sion.

As soon as it is recognized that the past rate of inflation has been accelerative, expectations arise that they will continue to be ac celerative. Still further compen sating reactions by individuals take place. This is still another reason why it is so hard to stop a long-term inflation. Even if the monet?-ry authorities halt the in crease in the money supply, price advances will tend to go on for a while. The Impact Is Uneven I must confess at this point that, in order not to introduce too many complications at once, I have been indulging in a danger ous oversimplification. This is to talk in terms of aggregates and averages - an aggregate increase in the money supply, an average increase in prices of such-and such per cent. Discussion in such terms can be grossly misleading if it involves the tacit assumption (as it sometimes does) that everybody is affected in the same pro portion, or that all prices rise simultaneously and by a uniform percentage. One of the chief con sequences of any inflation, on the contrary, is the wanton way in which it redistributes wealth and income.

The new credit or new money is always paid out first to certain specific groups, increasing their income; it is spent by them in turn to other specific groups, and these in turn deal with still other 78 THE FREEMAN February groups, until the new money has percolated through the whole com munity. The groups to whom the money goes first are benefited most; those to whom it comes last are hurt most. But the point at which the new money enters the economy also af fects the balance and structure of production. In an analysis pub lished in 1931, Prices and Produc tion, F. A. Hayek pointed out that an increase in the money supply made available to entrepreneurs through increased bank credit woulq. at first cause an increase in the demand of capital goods in relation to consumer goods, and hence would raise the prices of capital goods in relation to those of consumer goods. This would lead to an expansion of the capi tal goods industries in relation to the consumer goods industries.

But the same annual rate of in crease in the money supply would have to continue in order to main tain this new relationship. In fact, in order to bring about any fur ther relative expansion of the capital goods industries the new money or credit would have to increase at a constantly increas ing rate. And if the original mone tary inflation were not annually continued at at least the initial rate, there would be a reversal in the price relationship of capital goods and consumer goods, bringing on a relative forced shrinkage in the capital goods industries, leading to depression. The Addict's Dilemma So this is the dilemma that in flation finally brings us to. We have a tiger by the tail. If we try by inflation to keep the economy at a constant peak of full employ ment and expanding incomes we must constantly increase the pace of inflation, with a day of crack up and collapse inevitable in any case; and meanwhile even a gal loping inflation may be accom panied by bankruptcies and unem ployment. If we stop or even sub stantially slow down the i~flation, we are certain to disappoint ex pectations; we may face price de clines, insolvencies, unemployment, and at least a mild crisis.

But this does not mean that we should continue inflating. We should stop the inflation as soon as we can, and face the possibility of an immediate but relatively mild crisis to prevent far greater evils later on. Inflation has been sometimes compared to a drug. The comparison is even more apt than is imagined by most of the people who make it. When a youth takes a drug that he doesn't need in the first place, he has to take larger and larger quantities of it to experience the same lift or "high" - with increasingly de1970 INFLATION: A TIGER BY THE TAIL 79 moralizing consequences. But if he tries to halt, he may experi ence agonizing withdrawal symp toms. The Outlook What is the actual outlook to day? This is in any case difficult to say, and any forecast might be outdated by the time this appears in print. Powerful forces are op erating in both directions. The Federal Reserve Board, compared with the recent past, has been following a policy of severe mone tary restraint. As a result, the stock of money in the country, consisting of demand deposits plus currency held by the public, in creased from December to June at a 4 per cent annual rate, and from June to the end of October was practically unchanged. In com parison, money grew at an annual 7 per cent rate in the previous two years.

In addition to this record of monetary restraint, the unified Federal budget for the fiscal year 1970 has been planned to yield a surplus (though it may not be achieved) of as much as $6 bil lion. On the other hand, as soon as one result or accompaniment of monetary restraint was a slight increase in unemployment, the Nixon Administration came under sharp criticism. It remains to be seen whether the administration will be able or willing to hold to its course in restraining inflation. Congress has been recently vot ing increases in expenditures and reductions in taxes. The political pressures for continuing inflation are still enormously greater than the pressures for stopping it. ~ IDEAS ON LIBERTY Astronomical Inflation INFLATION may be troubling us Earthlings, but now it has taken on a deep space aspect. According to the National Research Bureau, back in 1891 a French widow allegedly left 100,000 francs (then worth $20,000) to the first man to set foot on a heavenly body.

Astronaut Neil Armstrong is theoretically in a position to col lect, but thanks to the inflation in France over the decades, that once-munificent sum now has a purchasing power equivalent to $180. Had an American widow made the same $20,000 bequest it would have suffered quite a severe shrinkage, too. Today it would have a purchasing power equivalent to $4,180. RIC H A R D H. M ILLER From the October 1969 issue of Brevits issued by Vance, Sanders & Company, Inc.